The Dow Jones FXCM Dollar Index (ticker = USDollar) dropped 1.2 percent this past week – the sixth drop in seven weeks. In this extension, many believe a larger bear trend is in place. Yet, critical determinations on the market’s view of risk trends and US-based rate forecasts this week must be made to establish the next trend.

Looking to the fundamental developments this past week, the greenback certainly has reason to be on the defensive. Investors, policymakers and the press from across the globe were consumed with the brinkmanship in the United States on the country’s debt ceiling. After weeks of a partial government shutdown, the world’s largest economy was on the verge of prioritizing payments and perhaps falling into technical default. The consequences of such a calamitous scenario would have threatened the entire financial system. Yet, an 11th hour agreement (the third in three years on this front) averted crisis.

Though the market may have suspected such an outcome, there was nevertheless a relief rally that was certainly measured in short-term Treasury yields (the rate on one-month bills retreated from multi-year highs) and sovereign Credit Default Swaps (CDS). Yet, the same respite wasn’t afforded to the dollar. In fact, following the encouraging news, the greenback posted a notable technical breakdown of support that has guided the currency throughout the year.

The immediate assumption upon seeing the dollar’s tumble is to connect it to the pulsating headlines of the S&P 500 hitting record highs. Removing a crisis would be occasion for a ‘risk appetite’ rally which buoys equities and sinks the benchmark reserve currency. A committed trend via investor sentiment would almost certainly put the dollar on pace, but there is reason to question that assumption. Looking outside of the US equity index’s performance, there was a concerning lack of corroboration to a genuine speculative build up. There was little momentum shared in global equities, carry trade, high yield assets and other asset types that would traditionally gain on a revived appetite for return and rebuke of risk.

Doubt surrounding the robustness of sentiment may not throw US equities off the scent, but we have seen the indexes deviate from other risk measures for some time – including the dollar. That being said, should this pacesetter for optimism take a dive; it would likely speak to a severity of fear that we have not seen in some time…before the broad safety net of stimulus was cast by the Federal Reserve. As it happens, we will have the opportunity to test the conviction of both risk and ‘moral hazard’ this week with the September NFPs.

Unlike regular payrolls releases, this update will print on Tuesday. That materially alters the volatility potential for the indicator. Normally, a Friday release will curb speculative activity in the lead up to the data, and a wind down to the weekend limits the immediate follow through. This time around, the data will instead act as the perfect igniter for settling a mixed risk outlook. It will accomplish this by the market’s natural reaction to any ‘surprise’ (deviation of the actual from the market consensus forcing repositioning) as well as adding color to the interest rate outlook.

In the FX world, interest rates and interest rate forecasts are among the most essential factors for gauging value. There are no near-term rate hikes in store for the US, but market-base yields (where money is made) can rise without a Fed Funds hike. The inevitable Taper was a significant market driver in the lead up to the September FOMC decision – boosting the dollar against an S&P 500 drive to record highs. When the central bank surprised the majority by deferring its QE3 taming effort, th initial reaction was as expected. Yet, the day following equities reversed lower and the dollar recovered. With the government shutdown, expectations for the first move to reduce stimulus have been pushed back all the way to the March 19 meeting. That is aggressive. With a market leaning towards risk (with dubious conviction) and the rate forecast set so far in to the future (perhaps too far); the market is pricing a perfect, bearish storm for the dollar. Should cracks develop in that picture – particularly on the jobs data – the dollar stands to recover a lot of ground quickly. - JK

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.